As mentioned before moral hazard is a problem of hidden action. In simple terms there is a cost involved in taking care and precautions to avoid a particular loss. When a party has full insurance, they have no reason to incur these costs since their insurance will fully cover the loss.

The probability (p) of loss (L) is endogenous and depends on the level of expenditure on care a1, a0, where a1 > a0 .

Set a0 = 0, now probability of loss when a = 0 is p0 ; and a = a1by p1 .

For it to be worth spending a1 care rather than a0 care, it is necessary that;

(p0 - p1)L > a1 or expressed another way; p1L + a1 < p0L

Now;

When the individual chooses a0= 0, the insurance companies break even budget line is the line B0y0.

The individuals budget line where they spend a0 = 0 is B'y0. When they spend a1it is B1a .

Where there is perfect information (i.e. no hidden action ) and the insurer can observe that a1 care has been taken it will offer full insurance anywhere along the new insurer break even budget line of B1a.

For the individual in Figure 1., it is clearly better to spend a1 on care since this will place them on a higher indifference curve I' then if they choose a0(which places them on the lower indifference curve I0 ).

But this is the situation under perfect information. As was mentioned before moral hazard occurs because of asymmetric information. The actions of one party (the insured) are not observable by the other party (the insurer). Now what if the insurer is unable to observe the level of care being taken? Consider the situation where they assume that the insured party chooses a1 level of care. In this situation;

The insurer will offer an insurance contract based on the break-even budget line B1a . The associated premium for full cover is given by p1L.

But, the insured can choose their level of care! They will choose a0 level of care as this will place them at the point A'1. This is on a higher indifference curve than the perfect information situation. The insured thus has an incentive to choose a0level of care.

This situation is clearly unfavourable to the insurer since it makes a loss, the expected payments exceed the expected premiums : p0L > p1L .

A situation of moral hazard thus exists.

How is moral hazard in insurance markets discouraged?

There are principally two techniques which insurers can employ to discourage moral hazard. Insurers can choose to either introduce a 'deductible' or introduce 'co-payments'.

A deductible is "A provision in an insurance policy under which the person buying insurance has to pay the initial damages up to some set limit" (Katz & Rosen (1994) p. 596). This would be more familiar to most people as the term 'excess'.

A co-payment is "A provision in an insurance policy under which the policyholder picks up some percentage of the bill for damages when there is a claim." (Katz & Rosen (1994) p. 596).

Which type of countermeasure should an insurance company choose to deal with moral hazard? This depends on the situation which it faces.

If the moral hazard is of the type that it is likely to increase the risk of a loss then the insurer should choose deductibles. This is because the use of a deductible saves the insurer money not only by encouraging greater care but also by reducing the cost involved in processing and dealing with small claims. (The Economist (1995) p. 66).

If the moral hazard will increase the size of the pay-out then the insurance company should choose co-payments. This is because the larger the loss the insured suffers, the larger the co-payment. Insured parties have an incentive to keep the size of the loss down.

Can deductibles be combined with co-payments?

It is worth considering whether insurers should combine deductibles and co-payments where the risk they are covering involves both types of moral hazard (i.e. increased risk and risk of larger payouts). It has been argued (The Economist (1995) p. 66) that combining both methods in the one policy may not always be a good idea.

Where making an early claim and addressing a problem sooner may reduce the eventual size of the payout then mixing deductibles with small co-payments may be bad. The deductible component may discourage making an early claim more than the co-payment encourages it, though clearly this becomes an empirical matter. "But combining big deductibles with big co-payments might deter people from buying insurance altogether" (The Economist (1995) p. 66).

How is the best means of addressing this sort of situation? The suggestion has been made that the appropriate response to this particular situation is to that insurers "should scrap deductibles altogether and replace them with bigger-than-usual co-payments." (The Economist (1995) p. 66).

Again however the problem is that the insurer may not know which of the two risks (more claims or larger claims) is the greater problem.

Given these two private responses to the problem of moral hazard in insurance markets, is there anything that governments can do? The answer lies in the introduction of taxation on activities which increase risk, and subsidy of activities that improve the care an individual takes.

If we return to the situation described previously. Consider the situation where:

The government offers a subsidy 's' on expenditure on care and activities which reduce risk.

The cost to an individual of reducing their probability of loss to p1 is now (1-s)a1 .

At the same time, the government introduces a lump sum tax of T = sa1.

This level of tax is paid now no matter what level of care an insured person chooses.

If the government sets s = 1 ; T = a1, then individuals will have an incentive to take care of a1since if they do not they will be worse off.

This sort of intervention might persuade insurance companies that on the break even contract line B1a they can now offer better coverage - e.g. lower deductibles or lower co-payments.

However government intervention, like the private decision relating to deductibles and co-payments, requires that the government have information about the optimal sizes of the tax and subsidy it offers.

There are a number of implications for government policy of the existence of moral hazard.

If the government decides to introduce a system of universal health care, i.e. a situation where the government assumes the role of the health insurer through the introduction of compulsory payments (a medical care tax) used to fund a public health system open to all with no extra payments. Moral hazard could lead to citizens taking less care of their health than where they must privately bear the cost of their actions. This may lead to rising costs in the health budget.

In the presence of universal health insurance and a public health system the government may need to introduce a variety of taxes and subsidies in order to reduce the moral hazard problem and pay for the rising health costs associated with a particular risky practice. E.g. higher taxes on tobacco products to discourage that risk activity and to finance the health care associated with smoking.

The other option open to the government to discourage abuse of the public health sector is the introduction of deductibles and co-payments. However if consumers are able to purchase private health insurance to cover the co-payments then the moral hazard remains.

Eliminating moral hazard and its effects on the health component of the budget thus becomes quite difficult, especially where private insurance exists along side public health and universal cover.